Third Party Liability in Insolvency Cases Favour Revenue Canada
In its recent decision in Caisse Populaire Desjardins de L’est de Drummond v. Her Majesty the Queen in Right of Canada, 2009 SCC 29, the Supreme Court considered a controversial topic in insolvency law: federal deemed trusts as they are applicable to payroll deduction. Justice Rothstein, writing for the majority, concurred with the Federal Court of Appeal decision favouring the tax authorities and dismissed the appeal. In essence, the SCC allowed a financial institution to repay its loans to tax authorities by way of setting off against its own term deposit when the borrower is also indebted to the tax authorities for payroll source deductions, thus creating a deemed trust in favor of the Crown.
The SCC’s conclusions have lasting and serious implications, as the court gave the rights of the tax authority priority over the rights of the financial institution as well as the undertaking of a term deposit from a third party. Holding the rights of the tax authorities supreme has led to many criticisms of this case. Many have complained that Revenue Canada – not satisfied with collecting payroll tax deductions from the proceeds of liquidations or director’s liability – is pursuing third parties who have had business dealings with the tax debtor and received property by way of payment. This decision may result in even a minor association with a tax debtor having the potential for negative ramifications for the third party.
Aside from these criticisms, it is clear that the SCC resolved two major issues in this case: first, the definition of “security interest”, where the federal definition prevailed over the provincial definition, and second, the relationship between contractual compensation or set-off and a security interest where the intention of the parties was deemed to be paramount.
The Facts of the Case
On September 25, 2000, Caisse, a credit union, granted a line of credit of $277,000 to Camvrac. In accordance with the “Terms Savings Agreement” signed by both the parties, Camvrac deposited $200,000 with Caisse providing that the deposit would mature on October 16, 2005. Caisse and Camvrac also signed a “Security Granted through Savings Agreement.”
One month after the loan was granted, Camvrac defaulted on their interest payments. After the default, Caisse took no steps to recover the defaulted payments and the line of credit continued to accrue interest until January 31, 2001. During this time, Camvrac filed for bankruptcy. On February 21, 2001, Caisse closed the Camvrac “Term Savings Agreement” noting “To be closed on 21/2/2001 to realize on security.” Finally, on June 12th, the Crown gave Caisse notice to pay the amount owing to the Crown for unremitted employment insurance premiums and income tax deducted at source by Camvrac. These payments were deducted from the proceeds of the term deposit.
Moreover, the clauses of the Agreement also supported Caisse’s position of using the deposit to repay the unremitted payments. As per clause 7 of the “Security Granted through Savings Agreement,” Caisse was entitled to use the deposit sum, regardless of the maturity of the deposit, to force compensation by reducing or eliminating Camvrac’s indebtedness to Caisse. Clause 8 of the Agreement further states that “failure by the Caisse to avail itself of any of its rights in case of default,” as was the case here, “shall not be interpreted as a waiver of such rights.”
Main Issue of the Case
The primary issue, as defined by Justice Rothstein, is whether section 227(4.1) of the Income Tax Act, R.S.C. 1985, c.1 [ITA] and section 86(2.1) of the Employment Insurance Act, 1996, c.23 [EIA] created a deemed trust in favor of the Crown such that the Crown was entitled to the unremitted employment insurance premiums and income tax deducted by Camvrac at source. Essentially, the SCC considered whether the Agreement between Camvrac and Caisse gave rise to a security interest that created a deemed trust, thereby justifying Revenue Canada’s attempts to use the deposit sum to pay off the unremitted payments.
Definition of “Security Interest”
Justice Rothstein delved into the details of the available statutes and determined the definition of “security interest”. He concluded that while the definition of “security interest” is similar to legal terminology used in personal property security and other legislation of the provinces, the definition in s. 224(1.3) of the ITA is the only relevant definition of “security interest” for the purposes of s. 227(4.1) of the ITA and s. 86(2.1) of the EIA. Interpreting the statutory language, he came to the conclusion that the federal definition as delineated in section 224(1.3) of the ITA is applicable in this situation, not the definition as set out in provincial legislation. Justice Binnie in Saulnier v. Royal Bank of Canada, 2008 SCC 58, also noted that “[f]or a particular purpose Parliament can and does create its own lexicon,” giving the federal legislation the requisite validation.
Other than the statutory justification above, there are also administrative reasons for using the federal definition rather than the provincial definition. Using the federal definition creates a national standard that does not change from province to province and is not subject to changing provincial legislation, maintaining uniformity and consistency in the long run.
As per the federal definition as set out in section 224(1.3) of the ITA, “security interest” is any interest in property created by an agreement over assets to secure the performance of an obligation, usually the payment of a debt. This interest generally gives the beneficiary rights to seize and sell the property to discharge the debt that the security interest secures. As per the facts of the case, Justice Rothstein concluded that “[t]hese agreements expressly conferred on the Caisse an interest in the property of Camvrac (i.e. Camvrac’s deposit) to secure repayment of Camvrac’s indebtedness to the Caisse.” Thus, this created a security interest.
“Security Interest” and Intention of the Agreement
A contract may explicitly provide for a right to compensate or right to set-off; however, it also gives rise to “security interest” as per section 224(1.3) of ITA. As with any contract, the terms of the contract have to be interpreted by the courts to determine the intention of the parties at the time the contract was made as reflected in the words of the contract – in this case, at issue was whether the parties intended to confer on a party “any interest in property [belonging to the other party] that secures payment of performance of an obligation”.
The courts determined that the mechanism for realizing the security, whether contractual compensation or set-off, is not significant. What is important is the substance of the agreement: “[i]f the substance of the agreement demonstrates that the parties intended an interest in the property to secure an indebtedness, then a security interest exists within the meaning of s.224(1.3) ITA.”
Finally, the SCC determined that as per the federal definition, contractual compensation led to the creation of a security interest, which was further supported by the intentions of the parties at time the contract was created. Section 227(4.1) of the ITA and section 86(2.1) of the EIA create a deemed trust in favor of the Crown over the term deposit that was then set off against the unremitted income tax and employment insurance payments.
This decision has the potential to have a significant impact on insolvency practice across Canada. By increasing personal liability, this decision widens the scope of financial institution liability where not only financial institutions, but all persons both dealing with tax debtors and receiving payments while a deemed trust exists may be liable. Widening this scope will have various repercussions for those found to be liable, including greater consequences and increased risks. It has the potential to make third parties stop and consider before entering into any agreement.
With greater risk, the want for greater return will surface, having the potential to change types of products available. This decision will also have important consequences on numerous financial instrument and derivative products that use the set-off or “netting” mechanism. Insurance premiums may increase because of the added risk, and banks will have to work harder to provide better returns.
In this case, the financial amount in question was small, yet its potential repercussions are many and widespread. If the SCC continues to follow this precedent, we can predict a veritable storm that may change the world of insolvency law as we know it today.